A 1031 exchange can be a valuable strategy for real estate investors, allowing them to defer capital gains taxes by swapping one investment property for another of like-kind. This strategy has long helped investors grow their wealth, but when dealing with mixed-use properties – those that serve both personal and investment purposes – the rules can become more complex.
Mixed-use properties are unique because they combine personal and investment use. In this blog, we'll explore how these properties qualify for a 1031 exchange, the tax implications, and why it’s critical to understand the rules around personal and investment use when deferring taxes.
What is a Mixed-Use Property?
A mixed-use property serves more than one function – typically combining residential and commercial or business uses. For example, a building with storefronts on the ground floor and apartments above would qualify as mixed-use. Investors are drawn to these properties because they provide multiple income streams, such as rent from tenants and revenue from commercial leases.
However, not every part of a mixed-use property may qualify for a 1031 exchange. To leverage the tax deferral benefits, it’s essential to distinguish which portions of the property are used for business versus personal use.
Examples of mixed-use properties can include:
- Farmland that includes a farmhouse on property
- Commercial building that contains both storefronts and apartments
- Single family home where first floor is used as an office and second floor is used as a primary residence
- Duplex where owner lives in one unit and rents the other
- Primary residence with a guest house they use as a rental year round
Eligibility of Mixed-Use Properties for a 1031 Exchange
To qualify for a 1031 exchange, a property must be held primarily for business or investment purposes. For mixed-use properties, only the portion of the property used for income-producing activities qualifies for the exchange. The personal-use portion is excluded.
Investors must carefully document the use of the property and allocate how much is designated for business or investment purposes. For example, rental units or commercial spaces would be eligible for a tax-deferred exchange, while the personal residence portion would not. Accurate allocation is essential to comply with IRS regulations and take full advantage of tax deferral opportunities.
Separating Personal and Investment Use
One of the key challenges with mixed-use properties is separating personal and investment use. Investors must document how the property is used and what percentage is dedicated to income-generating activities. For instance, in a property where the owner lives in one part and rents out another, only the rental portion is eligible for a 1031 exchange.
Clear documentation ensures that only the investment-use portion is eligible for tax deferral. The IRS scrutinizes these types of properties and ensuring proper separation between personal and investment use is crucial for avoiding potential tax issues.
Section 121 and 1031 Exchanges
Mixed-use properties often intersect with two important tax strategies: Section 121, which provides capital gains tax exclusions for primary residences, and the 1031 exchange. Investors need to know how to apply both strategies to maximize tax benefits.
What is Section 121?
Section 121 allows homeowners to exclude up to $250,000 ($500,000 for married couples) in capital gains from the sale of their primary residence, provided they’ve lived in the home for at least two of the last five years. This exclusion applies to the portion of the property used as a personal residence.
How does it affect 1031 exchanges?
For mixed-use properties, Section 121 applies to the personal residence portion, while the business-use portion can be deferred using a 1031 exchange. This allows homeowners to benefit from both tax strategies when selling a mixed-use property.
For example, if 40% of the property is used as a personal residence and 60% is rented out, the homeowner can exclude the gains on the personal-use portion under Section 121 while deferring taxes on the investment-use portion through a 1031 exchange. Proper calculations and documentation are necessary to ensure compliance.
Tax Implications and Considerations
When selling a mixed-use property, the tax implications can be complex. The pro rata basis calculation determines how much of the property’s gain is eligible for a 1031 exchange and how much is subject to capital gains taxes. In the example above, the pro rata basis will split the gains accordingly. The 60% would then qualify for tax deferral under a 1031 exchange, while the rest may be subject to capital gains taxes.
A CPA can help ensure accurate reporting and calculate the pro rata basis to comply with IRS regulations.
Benefits of Using a 1031 Exchange for Mixed-Use Properties
Beyond tax savings, a 1031 exchange allows investors to preserve more capital for future opportunities. Below are some of the key benefits.
Multiple income streams
In some cases, mixed-use properties can offer investors the potential for multiple income streams, combining residential rental income with commercial lease agreements. This can create a steady flow of revenue from different sources, making mixed-use properties particularly attractive for investors seeking stability.
Greater tax deferral
By utilizing a 1031 exchange, investors can defer taxes on the investment portion of a mixed-use property, allowing them to reinvest more capital into new opportunities. This deferral can significantly enhance an investor’s ability to grow their wealth over time, especially when reinvesting in other income-generating properties.
Portfolio diversification
1031 exchanges allow investors to reinvest in a variety of property types, including commercial, residential, and additional mixed-use properties. This flexibility enables investors to potentially create a more diversified real estate portfolio, spreading risk across different property types and income streams.
Is a 1031 Exchange Right For You?
By understanding how mixed-use properties qualify for a 1031 exchange and the benefits of using this powerful tax deferral tool, investors can make informed decisions about their real estate investments. Always consult your CPA to ensure you’re navigating the tax rules correctly and making the most of your investments.
If you’re interested in learning more or seeing if you qualify for an exchange, contact us at (239) 333-1031 and speak with a member of our team.
The role of Equity 1031 Exchange, LLC (formerly Midland 1031, LLC) as Qualified Intermediary is limited to acting as qualified intermediary within the meaning of Regulations section 1.1031(k)-1(g)(4) for Federal and state income tax purposes. In this regard, Equity 1031 Exchange is not providing other legal, investment, or due diligence services. The taxpayer/exchanger must direct all investment transactions and choose the investment(s) for the exchange. Nothing contained herein shall be construed as investment, legal, tax or financial advice or as a guarantee, endorsement, or certification of any investments, legal effect or tax consequences of the transfer, conveyance and exchange of the Relinquished Property and/or the Replacement Property.